Clear Eyed Capitalist

Progressive tax rates and excessive CEO salaries, related?

I’m blogging about listening to Piketty’s Capital on audiobook, page numbers refer to the hardcopy.

This week I listened to chapter 14 on the Progressive income tax – how it came about, what role it plays in preserving equality.

The progressive income tax is an important part of supporting the Social State – we need that much tax and if it’s regressive then Piketty contends that people will find the system unjust and be unwilling to participate. The Social State does require substantial funding, it got close to 50% of total national income at its peak. Folks were willing to move up to that point in the 50s & 60s because everyone was doing well. Further, it was implemented very progressively. “All told, over the period 1932-1980, nearly half a century, the top federal income tax rate in the United States averaged 81 percent.” (p 507) It actually peaked at 88% in 1942, with surtaxes that created a high of 94% in 1944, before falling to the 70% some of us remember. Piketty calls that kind of rate “confiscatory”, and suggests it’s motivated to address “incomes deemed to be indecent (and economically useless)”. (p 473)

Progressive income taxes were introduced right around World War I, and took hold in part because of the huge debts governments ran up in the war and had no other way to pay off. The Bolshevik Revolution of 1917 and worker strikes are also suggested as a factor. The United States actually introduced higher tax rates than in Europe, and Piketty attributes that to a reaction against “the hyperinegalitarian societies of Europe” as well as a response to the Great Depression. (p 506)

In the 1980s the US and Great Britain with Thatcher and Regan began to significantly cut top tax rates. My sense from this chapter is that part of the argument was that Germany and Japan were catching up to us technologically and we needed to get more competitive. That strikes me as a misguided argument now after earlier chapters talked about economic growth as being towards the current “technological frontier”. Rapid growth in the last near-century has been more about recovery from the two world wars than from technological advance and the catch-up of Germany and Japan was inevitable. The fear that they might slingshot past was misguided. Anyhoo, we did cut tax rates.

Piketty describes it thus: “After experiencing a great passion for equality from the 1930s through the 1970s, the United States and Britain veered off with equal enthusiasm in the opposite direction.” (p 508) One consequence? The explosion of CEO salaries. “If we look at all the developed countries, we find that the size of the decrease in the top marginal income tax rate between 1980 and the present is closely related to the size of the increase in the top centile’s share of national income over the same period…. Conversely, the countries that did not reduce their top tax rates very much saw much more moderate increases in the top earners’ share of national income.”

Why? “In the 1950s and 1960s, executives in British and US firms had little reason to fight for such raises, and other interested parties were less inclined to accept them, because 80-90 percent of the increase would in any case go directly to the government. After 1980, the game was utterly transformed…” (p 510)

Piketty continues “there is no statistically significant relationship between the decrease in top marginal tax rates and the rate of productivity growth…” so there’s no evidence that the rise of top salaries is justified. In an earlier chapter he goes into greater depth about the difficulty of rationalizing high CEO salaries, or correlating them in any way with performance when compared with similar companies and similar demonstrable economic performance. It’s all about negotiation. After comparing CEO salary variations across countries he concludes “only dissuasive taxation of the sort applied in the United States and Britain before 1980 can do the job” of reigning in high salaries, not corporate governance reform. (p512).

This section particularly catches my attention because in my own experience as an investor reward is the intersection between luck and motivation to negotiate, more than skill or merit. I have long believed that the only way to keep people from gaming the system is to reduce their incentives to do so. Sounds like Piketty concludes the same thing based on data.